The Advisors' Blog

I continue to be impressed (to use a polite term) by the complexity of 409A as it applies in the context of what I call the “fringe areas” of nonqualified deferred compensation under Section 409A. For someone who does this for a living (as I do), it should not be such a brain teaser to make a typical employment agreement safe from 409A foot-faults.

For example, to focus on just one recurring conundrum: Is it too late to tighten up a non-safe-harbor “good reason” definition to avoid a six-month delay in separation pay to a specified employee?

The answer depends on a number of factors, including:

– How far off the mark the existing good reason definition is,

– Whether you have a single-trigger or double-trigger termination arrangement,

– When employment termination might occur, and

– In the case of a double-trigger change-in-control arrangement, when the change in control might occur.

The “Good Reason” Definition Matters — Even if it is Never Triggered

As background, a “good reason” definition lists a number of employment-related indignities that if imposed upon an employee would allow her to resign and be entitled to the same severance benefits as if she had been fired without cause. Typical “good reason” triggers are a reduction in compensation, diminution of duties, or a forced relocation.

To secure a 409A exemption, the goal is to have an arrangement in which a “good reason” resignation is tantamount to an “involuntary termination” of employment. An involuntary termination can be a necessary component of both the short-term deferral exemption and the involuntary termination (two-times/two-years) exemption, but for very different reasons:

1. Under the short-term deferral exemption, an arrangement that provides for payment within a designated short time after the lapse of a substantial risk of forfeiture is not deferred compensation. Payment contingent upon involuntary termination is subject to a substantial risk of forfeiture. Resignation for a valid “good reason” is treated as involuntary termination.

2. Under the two-times/two-years exemption, the key is that the severance payment not be accessible in any manner other than an involuntary termination (which can include a resignation for a valid “good reason”).

If the contractual “good reason” definition does not meet the safe-harbor definition in Treas. Reg. §1.409A-1(n)(2)(ii), it still may be in the “close enough” category described in Treas. Reg. §1.409A-1(n)(2)(i). The problem is that you cannot be 100% confident that the Service would agree with your assessment of “close enough,” and there is probably not going to be an IRS agent standing by at the termination date to give a thumbs up or down. Some people yearn for more certainty.

For Those Who Yearn for More Certainty

Here are the possibilities of what you can do at this point:

– If you have an existing good reason definition that is “close enough” to be deemed an involuntary termination trigger (see Treas. Reg. §1.409A-1(n)(2)(i) to make an informed decision as to this), then there is still time in 2008 to change to the safe-harbor definition and be confident of the ability to satisfy either the short-term deferral exemption or the two-times/two-years exemption (assuming all other exemption requirements are met).

– If you have a single-trigger arrangement and the existing good reason definition is not “close enough” to be deemed an involuntary termination trigger, then it already is too late to change to the safe-harbor definition for purposes of regaining the ability to satisfy the short-term deferral exemption. This because the “bad” good reason definition makes the payment not subject to a substantial risk of forfeiture, and you can never regain that once is it lost. (Sound familiar?)

– BUT, if (1) you have a double-trigger arrangement (i.e., must first have a CIC followed by resignation for good reason or termination without cause), and (2) the CIC has not yet occurred and will not occur in 2008, then there is still time to change even a blatantly bad good reason definition to the safe-harbor good reason definition for purposes of regaining the ability to satisfy the short-term deferral exemption.

– Regardless of how bad your current good reason definition is, you can still change it to the safe-harbor definition and avail the (less generous) two-times/two-years exemption. This is because the two-times/two-years exemption is not concerned with whether the severance payment was ever subject to a substantial risk of forfeiture (so you can reform a woefully deficient definition), as long as it does not apply to a termination occurring in 2008). . Whew!

All This Just to Avoid a Six-Month Delay in Payment?

An executive who has negotiated a lenient good reason definition may well conclude that a six-month delay in payment is a small price to pay for the increased chance of triggering the severance payment in the first instance. That decision is a personal one and will be influenced by the facts and circumstances.

However, I am in the camp that it is generally worth positioning for a 409A exemption where possible (assuming the executive is willing to change the good reason definition) — not just to avoid the six-month delay but also to preserve flexibility to make changes to the agreement in the future without the worry of “substitution” issues and to avoid later complications if Congress pursues the annual dollar cap on Section 409A deferrals. Who knows how that cap and the ensuing rules would be applied to non-exempt separation pay arrangements.

Limited Time to Take Action

Whatever you do, be quick about it! As expressed in Notice 2007-78, the Service views the modification of a good reason definition as a change in time or form of payment, which must be done in 2008 to be within the transition rule – so it does not work if the termination of employment occurs in 2008. It’s a head-scratcher why a change to make the payment more difficult to earn upon termination of employment (by changing to a more stringent definition of good reason) is changing the time of payment – the payment trigger is “separation from service” in any event.

The key is that by availing an exemption, the change is avoiding the six-month delay for specified employees and is thereby accelerating payment, at least in part. Best to go ahead and make any changes to the good reason definition in 2008 if you are so inclined.

– Laura Thatcher, Alston & Bird